Sunk costs: too late!

Tebow trying to decide what to doSunk costs are costs that cannot be changed. You must pay them no matter what.

For example, suppose your team hired a celebrity quarterback who is well-liked and unusually lucky but can’t throw the ball very far. You’ve agreed to pay him $6,000,000 over three years. And suppose that you spend hundreds of thousands of dollars on training to teach him to throw the ball, and he still can’t seem to learn to throw the ball very far. Even if he sprains his ankle during the pre-season and can’t play ball all season, you still have to pay him $6,000,000. 

Sometimes you have already committed yourself to paying sunk costs (such as this football contract).  Other times, you have already spent the money, and feel committed to keep your investment, even though it was a losing bet.

You pay $1,000,000 for a small office building to house your new business.  Suddenly, new “cloud” technology allows you to put most of your operations on the web.  Should you stay off the cloud, and use the building anyway?  Should you keep the building empty until you need more space? 

Sunk costs sometimes trap business people into thinking that they should “make good” on their investments, instead of dumping them and moving on.

The common error is to think that sunk costs can be changed when, in fact, they can’t.

For example, suppose you spent four years in college studying archaeology. After you graduate, you can’t find a job. What do you do? Don’t quit! You spent too much time and money on your education to give up.  Keep looking for a job!  Or do you go back to college to learn something else?

The four years of time and money (the sunk costs) are gone. No amount of job-hunting or persistence will bring them back.  If you are looking for income, learn something new and get a real job.

Here are other ways that sunk costs fool us into doing the wrong thing:

  • We continue to use older technologies that were very expensive, when newer technologies are more effective and productive.
  • We “throw good money after bad” by fixing old machinery that could have been replaced for less money.
  • We continue to waste retail and production space with old, unprofitable products, instead of focusing on products with greater potential.
  • We raise employees to their “highest level of incompetence,” instead of hiring new employees with the skills and expertise that we need.
  • We ignore new opportunities, hoping that older declining operations will “turn around.”
This is not to say that you can never recover sunk costs.  Sometimes old assets can be resold or creatively used in more profitable ways.
Let’s go back to the celebrity quarterback: Suppose you retrain him as a running back.
Maybe you can rent your excess office space.
Maybe the archaeology student can teach history.

[Image: Tebow trying to decide what to do by Jeffrey Beall, on Flickr]

2 thoughts on “Sunk costs: too late!

  1. Mark,

    I’m curious about sunk costs as applied to real estate, both residence and rental. If below purchase price by 20k or more, what is the best course of action? Both rentals combined are slightly positive for cash flow, one slightly under, one slightly over.

    Thanks.

    • Dion –

      Purchase price, previous losses, previous costs, or any other factors will only confuse you. Ignore them completely because you can’t do anything about them.

      Rather, focus on future cash flows. If your choice is to keep the property or sell it, then compare:
      1. the future cash flow stream from renting it and
      2. the future cash flow from selling the property.

      Which would you prefer?

      If you want to get sophisticated, take into account the tax benefits of renting versus tax on capital gain/loss from selling.

      Thanks,

      Mark

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